Startup Valuation - The VC Method
Published by Ryan Junee September 20th, 2006 in Thoughts.
Anyone from the valley will agree there is a certain buzz in the air right now - a buzz veryreminiscent of the late 90s. Not only does it remind us of the good times, but also of thedangers of getting ‘caught up in the hype’. It seems everyone is all too aware of this becominganother ‘bubble’ - and everyone, including myself, seems to be cautious about valuing newstartups using ‘bubble era’ metrics.So how should one value a startup? It’s obviously a difﬁcult question because the companytypically has no revenues, few assets (apart from people and some IP), and cannot be traded ina market with enough participants (and enough information) to accurately determine a price.This post is a bit of an educational piece for those who wonder how VCs typically value astartup. The method I describe below, is one of the most widely used (often called the ‘VCmethod’). At the very least, this method provides a ballpark ﬁgure to start with, which can thenbe adjusted according to a variety of external factors. For more details on the VC Method, seeHBS Note 9-288-006.In describing this method I will start with a simple scenario of a company that takes only oneround of venture ﬁnancing, and then show how this method can be expanded to handlemulti-stage ﬁnancing.
The ﬁrst thing we need to calculate is a ‘terminal value’ for the company. That is, a value atsome point (say 5 years) in the future. This point may be an expected liquidity event (IPO oracquisition), or failing that should be a point where the company is at least earning a proﬁt. Weneed to
come up with a value for the company at that point in time. The easiest wayto do this is to look at a comparable company. For example, if a company in the same orsimilar industry was recently acquired or went public, this value can be used as a proxy for theterminal value of the company we are trying to value. Another, perhaps more commonmethod, is to look at price/earnings (PE) ratios for companies in the industry, and use thisalong with expected earnings in the terminal year as shown in the business plan (suitablydiscounted to adjust for EEE - Entrepreneur’s Enthusiasm Error :)Lets make this clearer with an example. Our company, Infelidoo, is expected to earn a $3Mproﬁt in year 5. Comparable companies in Infelidoo’s industry are trading at PE ratios of around 15. This means Infelidoo’s expected terminal value is $3M x 15 = $45M.Note: this terminal value is
- assuming everything goes right. We will account for thefact that everything doesnt always go right in the discount rate (see below).
The Venture Capitalist’s Required ROI
Lets say our VC is ready to invest in Infelidoo and needs to value the company. The companyneeds $2M to get started - and in this simpliﬁed example will need no more cash over the next5 years to reach its goal. Given the risk of this project, the VC decides she needs a 50% annualrate of return on her investment (more on determining the rate of return later).
Startup Valuation - The VC Method at Ryan Says…http://blog.ryanjunee.com/2006/09/startup-valuation-the-vc-m...1 sur 57/11/08 10:13